The Most Important Election ….
2020 began with a hotly contested primary between a large field of traditional and more progressive candidates. Soon after former Vice President Biden secured the nomination, the novel Coronavirus interrupted the normal political process. There have been almost no in-person events during the year and the candidates and their surrogates have waged media driven campaigns. As with every election, passions are high, and many prognosticators warn that this is the most important election in the country’s history.
While the political stakes are high, we do not believe it’s prudent to reallocate investment portfolios in anticipation of election results for two reasons. The first reason is that it’s very difficult to determine the results of competitive political contests. Next, and more importantly, it is impossible to anticipate how the markets will respond to elections even if one were to correctly predict the outcome.
Polling is both a science and an art. Pollsters ask questions to try to determine how likely a respondent is to vote and who they will vote for in an election. Many people do not answer these questions honestly for privacy or other reasons. Sample sizes of respondents are also limited so that algorithms must be applied to extrapolate limited responses to the broader electorate. Estimates are also based on historical patterns that may not repeat in the future.
On November 8, 2016, Nate Silver’s website, FiveThirtyEight, predicated that Hillary Clinton had a 71.4% chance of winning the 2016 election and that she would win 302 electoral votes versus Donald Trump’s 235. Silver has an exceptional predictive record and while he gave Donald Trump a better chance than most professional forecasters, he still did not make Trump the odds-on favorite. He and many other forecasters didn’t accurately predict who would show up to vote. As of late September, Biden is roughly a 75% favorite to win the presidency; however, according to these odds, Trump still has a 25% chance, which is not insignificant or dissimilar to four years ago.
While the presidency is always extremely important, who controls the Senate may have a greater impact on what legislation passes over the next four years. In the current Senate, the Republicans hold a majority of 53 seats compared to 45 for the Democrats (47 including the two independents that caucus with the Democrats). The Republican Senate has blocked numerous bills voted out of the Democratic House of Representatives over the last two years. Of the 35 Senate contests this year, the Republicans are defending 23 seats while the Democrats are only defending 12 seats. Recent data suggest the Democrats have a 60% chance of controlling the Senate, but the party’s margin could be a slim 51/49 split. Many races, such as the contest in Iowa, are too close to call. The difficulty of predicting who votes in the races makes it extremely difficult to determine an outcome.
Even if one were to accurately predict an election, it would be impossible to then determine how the markets react. Markets reflect millions of individual buying and selling decisions based on numerous factors. Sentiment can change instantaneously and often there is no one logical explanation for a particular market movement.
During the last presidential election, the markets sold off aggressively after-hours once it became known that Donald Trump defeated Hillary Clinton. During the evening of November 8, 2016, the Wall Street Journal reported that S&P futures fell by 5%. However, the market reversed when it opened and closed over 1% higher for the day so that the total swing in value was over 6% just due to sentiment.
Following is a table showing S&P 500 annualized returns in each of the last 11 presidential administrations since WWII:
Stock returns have been higher during periods when Democrats were presidents, but most of the differential is due to negative market returns during the Nixon/Ford period and G.W. Bush’s presidency. The early 1970s were negative for markets due to oil shocks and high inflation while Bush served through the bursting of the tech and housing bubbles which coincided with the beginning and end of his term in office. Returns during Clinton’s presidency were similarly boosted by the technology driven expansion of the late 1990s.
Market returns were also higher during periods when Congress was not controlled by either party for the length of a particular presidential cycle. While there are too few data points, this differential makes sense since companies like predictability. Periods when power is split between the parties in Congress prevents either side from pushing their policies in more partisan directions.
Whoever wins the upcoming Presidential election will control the executive branch which influences a tremendous amount of government. We believe the Congressional election is more pivotal. If the Democrats sweep, their agenda will go forward whereas if the Republicans maintain the Senate, there will be a stalemate as in recent years without large bills. While the election may bring about significant changes, we do not believe it’s prudent to alter portfolios based on speculation regarding the outcome.
Amazon and Tesla- 2 story stocks
Year to date, overall market performance has been driven by a handful of stellar performing stocks. Among these are two that can be quite polarizing – Amazon (AMZN) and Tesla (TSLA). Both are good stories, but what are the fundamentals saying?
We use a stock’s fundamentals to better understand its underlying fair value, which we evaluate through two lenses. How much will investors be willing to pay for the company’s earnings in 3-5 years (an earnings multiple model) and what is the value of the company’s future cash flows (a discounted cash flow model or DCF)? Both processes should yield a similar result.
AMZN has had a banner year through the end of Q3, up more than 70% and is among the three largest companies in the world. The surge in price has been driven by the pandemic and the company’s execution. After 21% revenue growth in 2019, estimates called for 31% revenue growth in 2020. The pandemic has driven more commerce online and there’s no question AMZN is a beneficiary as the core retail business is now driving growth. AMZN’s Webservice (AWS) is slowing from its mega-growth, like all the hyperscale cloud providers, as they run into the law of large numbers. The company can grow revenue, but the underlying retail market is hyper competitive with low margins (AMZN’s trailing net margin is 4%). While AWS is most likely highly profitable and AMZN has a growing and most likely profitable advertising business, the remaining 80% of AMZN’s business is not so highly profitable. Importantly, AMZN’s competitors are not small potatoes. AWS competes with Microsoft and Alphabet while the advertising business is also competing with Alphabet via Google search. Walmart is increasingly becoming an online retail competitor, especially after its Jet.com purchase and recent introduction of a subscription service (Walmart+) offering free delivery and other benefits, comparable to AMZN’s Prime. Prime includes video, a crowded space – think Netflix, as well as free shipping. Apple is in the video and music space as well, and recently introduced its own subscription service combining TV, Music, News and other products. While competition doesn’t mean consumers will cancel their Prime subscription services, or stop using AMZN for shopping, they do decrease the company’s pricing power.
At the beginning of the year, investors were willing to pay 80 times earnings for the company, about four times the average stock. Investors are now willing to pay even more as the stock trades at a price to earnings (P/E) ratio of about 120. We have reviewed AMZN and made the conscious decision to not include the company in our portfolios. While its growth is impressive and it is the dominant player benefiting from a secular trend (i.e. more e-commerce), investors are very aware and have bid up the stock. We cannot be confident that the market will continue to pay these multiples; therefore, the earnings multiple model says AMZN is too expensive. Additionally, we are not confident in the company’s pricing power given the competitive markets in which it operates. This lowers our estimate of future margins and future cash flows. As a result, the DCF model also says AMZN is too expensive.
The conclusion is AMZN is a well-written story but without a perfect ending, it’s not worth the price.
TSLA has had an even better year than AMZN, up over 400% as the market went from paying 3 times sales to 15 times sales. TSLA’s P/E ratio started the year incredibly high, and while it has come down, the quality of the “E” is in doubt. The AMZN decision was based on can the fundamentals justify the price? TSLA was more a question of can the company generate profits? They make great cars- anecdotally all TSLA owners we’ve met love their cars. However, over the last 26 quarters (6+ years), the company has been profitable without regulatory credits just 4 times. In the most recent quarter, TSLA had net income of $104M while revenue included $428M in regulatory credits. TSLA receives these credits due to its all electric lineup, and sells them to other car manufactures, which then use the credits to comply with emissions regulations. These credits are all profit, so remove the credits from last quarter and the company’s earnings are gone.
Over the last 5 ½ years, the company has generated negative $6B in free cash flow. The company has offset this negative flow by issuing $5.9B in debt and another $7B in equity. Issuing equity has been a boon for the company as they don’t have to pay it back. In fact, some analysts became bullish on the company after the most recent equity raise, the logic being that as the stock goes up, equity becomes “cheaper”, allowing the company to raise more cash, further driving up the stock price. This works well until it doesn’t; for example, a company heading to bankruptcy would have little success raising cash by issuing equity.
The story nature of TSLA was demonstrated by the 20% fall after the company was not added to the S&P 500. The assumption was the company would be added, and once it wasn’t, the stock fell despite no change in the underlying business. The stock recovered partially driven by anticipation over Battery Day. This included speculation that TSLA will dominate the stationary battery market as battery revenue climbs from the current $1.5B to over $200B in 10+ years. This makes for a nice story but does not give us confidence in whether the market will continue to pay such high multiples. That viewpoint was reinforced when Battery Day disappointed and the stock fell. Our DCF model fails to support a purchase of TSLA due to the speculative nature of its future cash flows.
Our conclusion is TSLA is a great fantasy that may be on the path to a scary ending. In the best interest of client portfolios, we try to avoid stories with scary endings.
2020 Year-End Planning Reminders
As we approach year-end, it is beneficial to review personal finances with a view toward limiting income tax liabilities. Noted below are topics for consideration, including several “one-time” opportunities enacted under the CARES Act:
Gross Income Exclusions
- Required Minimum Distributions (RMDs) from qualified retirement plans and inherited IRAs were waived/suspended under the CARES Act for 2020. If a distribution was taken early in 2020 and returned on or prior to August 31, 2020, income tax will be avoided on the distribution.
- Individuals who withdrew “qualifying coronavirus-related distributions” in cumulative amounts up to $100,000 between January 1, 2020 and December 31, 2020 from eligible retirement plan arrangements have two options available to minimize or eliminate income tax liability on the distributions:
- Report the distribution ratably over 2020, 2021, and 2022.
- Repay some or all of the distribution within three years after the date the distribution was received. The amount(s) repaid will not count as taxable income.
Adjustments to Gross Income
- Deflationary statistics could result in either a decrease or no change in allowable retirement plan contribution limits for calendar year 2021, because annual funding limits are adjusted and rounded down to the nearest $500. Therefore, we recommend that you:
- Review paystubs to maximize 401(k)/403(b)/457(b) & IRA contributions for 2020 to ensure you are taking optimum advantage of retirement funding opportunities.
- Individuals participating in employer 401(k)/403(b)/457(b) plans may contribute up to $19,500 ($26,000 if age 50 or older) in 2020. IRA contributions for eligible taxpayers of $6,000 ($7,000 if age 50 or older) may be made for 2020 up to and including the filing date of the income tax return (generally April 15, including extensions to file).
- Beginning this year, there is no longer an age limitation on contributions to IRAs (Traditional and Roth) by individuals who earn income from employment.
- For future planning, retirement contribution limits are typically released by early November for the ensuing calendar year.
- Charitable Contributions up to $300 for non-itemizers may be claimed as an above the line deduction this year under the CARES Act legislation.
Itemizing Deductions:
- Medical expenses will become subject to a higher adjusted gross income (AGI) phaseout limit of 10% beginning in 2021, vs. the 7.5% of AGI phase-out that has been extended through 2020.
- State/city income taxes, real estate taxes and personal property taxes in the aggregate are deductible up to only $10,000 in 2020.
- Don’t overlook the possibility of a casualty loss itemized deduction this year. Many of us in the Northeast Region were affected by Tropical Storm Isaias in early August. Casualty losses are considered an itemized deduction, and allowable to the extent that they exceed 10% of Adjusted Gross Income.
- Charitable contributions are income tax deductible up to 100% of Adjusted Gross Income this year, per CARES Act legislation. This limitation is expected to decline in 2021 to the prior level of 60% of AGI.
Additional Planning Information
- Converting Traditional IRA account balances to Roth IRAs (Roth Conversions) may make sense in 2020 given present low marginal income tax brackets since Roth IRAs do not require RMDs.
- Annual Exclusion Gifts (up to $15,000 per recipient) and Adjusted Taxable Gifts (gifts in excess of $15,000 per recipient) may be desirable using appreciating assets for those taxpayers seeking to reduce the size of their taxable estates.
- Federal estate taxes are assessed on cumulative lifetime transfers over $11.58 million. Note that certain states such as Connecticut ($5.1 million) also have estate and gift taxes which require planning.
- Reviewing IRA beneficiaries also makes sense since last year’s SECURE Act required all IRA beneficiaries (excluding surviving spouses) to receive their distributions within 10 years.
- RMDs in 2021 for retirement plan account beneficiaries will be based on updated actuarial tables, which will result in slower distributions of retirement benefits.
The above information is provided for your general information only. Individuals are encouraged to contact their professional tax advisers prior to implementation of the above information to determine which, if any, items may be appropriate.